Before the Federal Income Tax
The tax mechanisms used during first 150 years or so of U.S. tax history bears little resemblance to the current system of taxation. First, the U.S. Constitution restricted “direct” taxation by the federal government – meaning taxes directly on individuals. Instead, the federal government relied on indirect taxes including taxes on imports (tariffs) and excise taxes. Tariffs were the major source of U.S. government receipts from the beginning of the nation up to the early 1900s. For example, in 1800, custom duties comprised about 84% of government receipts. Internal federal revenue collections (which exclude tariffs on imports) as recently as the early 20th century were primarily derived from excise taxes on alcohol. In 1900 over 60% of internal revenue collections came from alcohol excise taxes with another 20% from tobacco excise taxes.
Another important difference is the scale of government taxation and expenditures relative to the entire economy. Government spending is currently a major portion of the total U.S. economy – in 2002 government expenditures and investment at all levels comprised about 20% of total economic output. In the late 1800s government expenditures were responsible for only about 2% of national output (earlier data on national output are not available). The role of government has become more prominent as a result of expansion of military activity and an increase in the provision of public services. Consequently an overall trend of increasing taxation is evident, although we’ll see that this trend has recently stabilized or reversed.
The Constitutional framers were wary of a government’s power to tax. Taxation of the American Colonies by a distant and corrupt England was a driving force behind the American Revolution. Consequently, they believed in decentralized taxation and delegated most public revenue collection to localities, which relied primarily on property taxes. During peacetime the federal government met its expenses through relatively modest excise taxes and tariffs. During wars, such as the War of 1812, federal taxes were temporarily raised to finance the war or pay down the ensuing debts. Once the financial crisis passed, taxes were reduced in response to public opposition to high tax rates.
Like previous wars, the Civil War initiated an increase in both excise tax and tariff rates. Government revenue collections increased by a factor of seven between 1863 and 1866. Perhaps the most significant tax policy enacted during the Civil War was the institution of the first national income tax. Concerns about the legality of the tax, considering the Constitution’s prohibition of direct taxation, were muted during the national emergency. The income tax rates were low by modern standards – a maximum rate of 10% along with generous exemptions meant that only about 10% of households were subject to any income tax. Still, the income tax generated over 20% of federal revenues in 1865. After the war, few politicians favored the continuation of the income tax, and in 1872 it was allowed to expire.
The impetus for the modern federal income tax rests not with a wartime emergency but with the Populist movement of the late 1800s. The tax system in place at the time, based primarily on excise taxes on alcohol and tobacco, was largely regressive. The Populists revived interest in an income tax as a means to introduce a progressive tax based on ability to pay. They saw it as a response to excessive monopoly profits and the concentration of wealth and power. In other words, the tax was not envisioned as a means to generate significant additional public revenue but as a vehicle of social justice.
A federal income tax, with a large exemption of $4,000, was instituted in 1894 but the Supreme Court ruled it unconstitutional in 1895. Over the next couple of decades proposals were made for a constitutional amendment to establish a federal income tax. While these attempts were defeated, support for federal income taxation gradually increased. Eventually, in 1913 the 16th Amendment to the U.S. Constitution was ratified creating the legal basis for the federal income tax.
While the initial income tax was progressive, it was less radical than many desired. In fact, many conservatives expressed guarded support for the measure to prevent a more significant tax. While the income tax was targeted towards the wealthy – in the first few years only about 2% of households paid any income tax – tax rates of only 1%-7% prevented it from generating significant revenues.
“...virtually none of the income tax proponents within the government believed that the income tax would become a major, yet alone the dominant, permanent source of revenue within the consumption-based federal tax system.” (Brownlee, 1996, p.45)
These views were to quickly change as the nation required a dramatic increase in revenues to finance World War I.
The Growth of Direct Taxation
Rather than relying on increases in excise taxes and tariffs to finance World War I, the administration of Woodrow Wilson transformed the income tax framework laid down just a few years previously. Desiring both to raise additional revenue and enforce social justice, the top marginal rate increased dramatically from 7% in 1915 to 67% in 1917. Corporate taxes also became an important revenue source, accounting for over one-quarter of internal revenue collections in 1917. In 1916 the estate tax was created, not necessarily to generate revenues but as another instrument of progressive taxation.
Unlike previous wars, much of the tax system laid down during World War I remained in place after the war. In the period from 1910 to 1925 tariffs fell from about half of government receipts to less than 15%. Meanwhile the new corporate and individual income taxes made up nearly half of government receipts in the mid 1920s. The level of excise tax collections dropped significantly, especially during the years of Prohibition when alcohol excise taxes virtually disappeared.
The Great Depression, of course, caused a significant decline in federal receipts. In 1932 tax rates were increased in an attempt to boost federal revenue. Franklin Roosevelt, in the years leading up to World War II, presented progressive taxation as a key element of the New Deal. The most significant tax-related measure enacted during this period was the creation of old-age insurance.
Prior to national social insurance programs, poverty was the common state of the elderly. By the 1930s, several European countries had already instituted programs of social insurance. Germany was the first to establish old-age and survivors pensions in 1889. The Great Depression finally motivated policy makers in the U.S. to enact similar legislation. Rather than funding Social Security programs through increases in income, or other, taxes, the funding mechanism was a separate tax, split equally between employers and employees. All employees covered by the system contributed and received benefits regardless of their income. This design was intended to protect the system from political attack. As everyone receives benefits, Social Security is not considered a “welfare” program. Also, because Social Security is a separate tax, contributors view their old-age payments as entitlements and oppose attempts to weaken the program. This design has so far proved successful – Social Security is often called the “third rail” of American politics (i.e., touch it and you die).
World War II created yet another emergency situation requiring additional revenues. Similar to Woodrow Wilson during World War I, President Franklin Roosevelt sought to raise revenues primarily from higher taxes on corporations and high-income households. Roosevelt went so far as to state that:
In this time of grave national danger, when all excess income should go to win the war, no American citizen ought to have a net income, after he has paid his taxes, of more than $25,000. (Brownlee, 1996, p.91)
Roosevelt was unable to obtain enough Congressional support to enact his most progressive proposals. The ensuing compromise did produce a more progressive federal income tax but it also became levied on more households. Personal exemptions were reduced by half between 1939 and 1942 – meaning the income tax reached well into the middle class for the first time. The taxable income subject to the highest marginal rate dropped from $5 million in 1941 down to $200,000 in 1942. Also, the top marginal tax rate reached a record high of 94% in 1944. Another change during World War II was withholding federal taxes from an employee’s paycheck rather than requiring payment of taxes due at the end of the year. These, as well as other, changes produced a dramatic shift in the structure of federal taxation:
Under the new tax system, the number of individual taxpayers grew from 3.9 million in 1939 to 42.6 million in 1945, and federal income tax collections over the period leaped from $2.2 billion to $35.1 billion. By the end of the war nearly 90 percent of the members of the labor force submitted income-tax returns, and about 60 percent of the labor force paid income taxes. … At the same time, the federal government came to dominate the nation’s revenue system. In 1940, federal income tax had accounted for only 16 percent of the taxes collected by all levels of government; by 1950 the federal income tax produced more than 51 percent of all collections. Installation of the new regime was the most dramatic shift in the nation’s tax policies since 1916. (Brownlee, 1996, p. 96-97)
As in the period after World War I, much of the new tax structure instituted during World War II remained in place after the war. Both major political parties expressed support for a progressive but broad income tax, relatively flat tax rates on corporate profits, and regressive social insurance taxes. Public support for the tax system was boosted by patriotic feelings and broad-based economic growth after the war.
Changes to the tax system between the end of World War II and the 1980s were generally minor. The Social Security tax occasionally increased as more people were receiving benefits. The initial tax rate of 2% (1% each for employers and employees) had increased to 6.13% by 1979. The Medicare and Medicaid programs were established in the 1960s. Across-the-board tax cuts in 1964 reduced marginal rates for both low- and high-income households (the top marginal rate fell from 91% in 1963 to 70% in 1965). Still, government continued to become a more significant portion of the entire economy in the decades after World War II. Total government expenditure and investment increased gradually from less than 18% of gross domestic product (GDP) in 1946 to over 22% by the mid 1970s.
From the “Reagan Revolution” to the Bush Tax Cuts
The general stasis of the federal tax system ended in the 1980s with several important tax changes. President Ronald Reagan was elected in 1980 on a platform of smaller government and lower taxes. The Economic Recovery Tax Act of 1981 (ERTA) enacted the largest tax cut in American history and inspired tax cutting by many other nations in the 1980s. The supply-side rationale behind ERTA’s sharp reduction in tax rates, particularly on high-income households and capital, was that these incentives would motivate increased investment and economic activity. The ensuing economic growth and consequent tax revenue growth would, in theory, more than offset the revenue reductions from the tax cuts. Thus, the theory was that tax cuts could actually produce an increase in federal revenues and reverse the growing federal budget deficit. ERTA phased in a reduction in the top tax rate from 70% to 50%, enacted several corporate tax cuts, and indexed many tax parameters to inflation (such as personal exemptions and deductions).
Analysis suggests that, in reality, ERTA resulted in the largest reduction in federal revenues of any tax bill since World War II. The federal budget deficit continued to grow and the very next year, in 1982, the largest peacetime tax increase was passed. The Act repealed some of the more revenue-reducing provisions of ERTA, such as accelerated depreciation reductions for corporations, and closed several corporate loopholes in the tax code. Social Security reforms were enacted in 1983 that increased Social Security tax rates and initiated taxation of some benefits.
Reagan continued to push for further tax changes, leading to the Tax Reform Act of 1986 – considered to be the most comprehensive revision of the tax code since the 1950s. This reduced top income tax rates even further – from 50% in 1986 to 28% in 1988. Among other changes, it also lowered the top corporate tax rate from 46% to 34%.
Clearly, the “Reagan revolution” is an important era in U.S. tax history, but many people misinterpret it as a period where the size of the federal government was drastically reduced and taxes cut significantly. Despite the two major tax cuts during Reagan’s terms, federal revenue collections increased at nearly the same pace as national output (total federal revenues increased about 76% from 1980-1988 while GDP increased 83%). The changes were more evident in the distribution of federal revenues than their total level. The share of revenues from individual and corporate taxation fell (by 9% and 16% respectively) while the portion from social insurance taxes increased by 38%. As individual and corporate taxes are progressive and social insurance taxes are regressive, the outcome was a decrease in the progressivity of the federal tax system.
The Reagan era failed to control the growing federal deficit. The annual budget deficits of the federal government tripled during the 1980s. Partly to raise additional revenue to try to reduce deficits, the first President Bush reneged on his campaign promise of “no new taxes” and agreed to a compromise tax proposal in 1990 that raised the top marginal tax bracket to 31%. President Clinton reinstated additional progressivity in 1993 by creating the 36% and 39.6% individual tax brackets. In 1993, the corporate tax rate was increased slightly to 35%. These changes produced an increase in the progressivity of federal taxes.
The most recent important tax legislation was the $1.35 trillion Bush tax cut passed in 2001. The major provisions of this act include lowering individual income tax rates across-the-board, scheduling repeal of the estate tax in 2010, and increasing the amount employees can contribute under various programs for retirement purposes. Many of the bill’s provisions are “back-loaded,” meaning the tax reductions are phased in over time with most of the tax reduction occurring in the future. For example, the top bracket fell from 39.6% in 2001 to 38.6% in 2002 but will eventually fall to 35.0% in 2006. The Bush tax cut reduced the overall progressiveness of the federal income tax as high-income taxpayers received a disproportionate share of the total cuts.
A somewhat smaller tax cut was passed in 2003 that, among other changes, accelerated scheduled tax rate decreases and lowered the maximum tax rate on capital gains and dividends. The official cost of the 2003 tax cut was about $350 billion over ten years. However, this estimate assumes the “sunset” of many of the bill’s provisions scheduled to last only a certain period of time. For example, the bill increases the child tax credit from $600 to $1,000 per child, but only for 2003 and 2004 – in 2005 the $600 credit would be reinstated. If such provisions are renewed, a likely political outcome for many of the provisions, the actual cost of the tax cut will be much higher.
Summary Data of U.S. Tax History
Until quite recently, tax collections have tended to increase over time, paralleling the increase in the size of the federal government. We see in Figure 1 that federal tax revenues have grown considerably during the 20th century, even after adjusting for inflation. A large increase occurred during World War II, with relatively consistent growth after about 1960. Occasional declines in federal tax revenues have been due to recessions or major tax code changes. The growth of state and local tax collections, by comparison, has been steadier with less fluctuation. The reason is that state and local tax revenues are derived primarily from property and sales taxes, which vary less than personal and corporate income during business cycles.
Another way to illustrate the growth of federal taxation is to measure it relative to national economic output. In Figure 2 we plot federal and state and local tax collections as a share of gross domestic product (GDP). Two facts are evident from Figure 2. First, total tax collections have generally grown as a percentage of GDP over the 20th century. Again, the largest leap occurred during World War II, but some additional growth is evident after the war as well. The other fact is that federal tax revenues now substantially exceed state and local tax revenues. While World War II solidified the federal government as the primary tax collector in the U.S., note that this trend began prior to the war.
As federal revenues grew during the 20th century, the composition of taxation has changed considerably. We see in Figure 3 that at the beginning of the century federal taxation was dominated by excise taxes. Except for a revival of excise taxes during the Depression Era, their importance has generally diminished over time. Corporate taxes became the most significant source of federal revenues for the period 1918-1932. After a period of higher corporate taxes during World War II, corporate taxes have generally diminished in significance relative to other forms of federal taxation. Personal income taxes became the largest source of federal revenues in 1944 and have remained so. Since World War II, income taxes have consistently supplied between 40-50% of federal revenues. Since about 1950, social insurance taxes have increased their share of federal revenues from about 10% up to nearly 40%. In fact, social insurance taxes may soon exceed personal income taxes as the largest source of federal revenues.
The composition of state and local taxes, with its increased reliance on sales and property taxes, differs from the composition of federal taxes. Of course, each state has a different tax system – some states have no income and/or sales taxes, and tax rates can differ significantly across states. In this article, we combine tax data for all states rather than presenting a state-by-state analysis. Figure 4 presents the composition of state and local taxes over the period 1945-1999. The two major trends that are evident are a decline in the importance of property taxes and an increase in the importance of personal income taxes. While property taxes were once the primary source of state and local revenue, sales taxes are currently the major source of revenues.
- Global Development And Environment Institute, Tufts University